02 Mar 2012 Meridian - 2011 Annual Letter ( Portfolio )
The broader stock market indices posted strong fourth quarter results but ended 2011 relatively flat. The S&P 500 index finished essentially unchanged for the year, the NASDAQ down 1.8% and the Russell 2000, which includes smaller companies, dropped 5.5%. Concerns over Europe, U.S. growth and government debt levels were mainly offset by continued corporate earnings growth and low interest rates. The year’s best performing sectors included consumer nondurables, health care and utility stocks. Basic material, financial and industrial companies were among the worst performing groups. The yield on the ten-year Treasury bond declined significantly from 3.30% to 1.87% during 2011. This drop, in our opinion, was due to sluggish economic growth and a flight to safety by investors.

We begin 2012 with the economy growing at a modest pace, historically low interest rates and moderate inflation. GDP grew at a revised 1.8% during the third quarter and is expected to have accelerated somewhat during the quarter just ended. Manufacturing and consumer spending are growing, while construction and employment have recently improved from depressed levels. There remains, however, considerable uncertainty. The viability of the European Union in its current form is questionable and a number of the members will likely experience negative growth in 2012. The U.S. Government, it appears, will not deal with long term deficit reduction, entitlement reform, tax policy, health care or other measures to promote economic growth until 2013, if then. We believe the economy will continue to expand this year, but at a subpar pace compared to other recoveries since World War II.
Long-term investment results, history clearly shows, are improved by buying good companies or mutual funds consistently over an extended period of time. We welcome those new shareholders who joined the Meridian Funds during the quarter and appreciate the continued confidence of our existing shareholders.

Our investment strategy remains unchanged. We continue to seek out-of-favor companies typically having experienced an extended period of declining earnings. In recent years most earnings problems have been related to poor economic conditions. With some stability in the economy, albeit tenuous, we now see more companies that meet our strategy for company- specific reasons. These investments are the traditional strength and point of differentiation of the Meridian Value Fund. We seek to gradually shift the portfolio to more of these investments and expect that this should bode well for a return to the Fund’s historically strong performance levels. We hold 50 positions, representing 33 industry groups. We continue to invest in companies of all market capitalizations and our largest areas of concentration are technology, retail and transportation.

During the quarter we purchased shares of Lennox International. We sold our positions in Heartland Express, Kohl’s and Sealed Air.

Hawaiian Electric Industries, Inc., one of our larger holdings, is the dominant electric utility in Hawaii. The company also owns American Savings Bank, the second largest bank in Hawaii, which contributes roughly one third of earnings. Earnings declined as years of strong economic growth in Hawaii spurred high demand for electricity that outstripped the company’s infrastructure, leading to elevated operating and maintenance costs. Bank earnings declined during the financial crisis, although conservative management cushioned the blow significantly compared to most banks. Earnings growth has resumed as rate increases now cover some of the increased utility operating costs. Further relief should come in 2012 and beyond due to an improved rate adjustment mechanism that encourages conservation and as new generating capacity comes online and earns double-digit returns on investment. The bank is also showing improved performance as the resilient Hawaiian economy outperforms the mainland. We expect earnings to grow from estimates of $1.43 per share in 2011 to $2.35 per share or more over the next 3 to 5 years. We believe the stock is a compelling value at less than 11 times normalized earnings and with a current dividend yield close to 5%.